Hannah Rounds

As mortgage rates tick upward, refinancing is becoming cost effective for fewer and fewer homeowners. Are the Federal Reserve’s recent rate hikes to blame? What about its so-called “normalization” policy? The Fed’s actions have some influence over mortgage refinance rates, but it doesn’t control mortgage interest rates. In fact, the Fed doesn’t control any interest rates.

In this post, we’ll talk about how the Fed actually impacts refinance rates.

What is the Fed?

The Federal Reserve (the Fed) is the central bank of the U.S. Its goal is to promote a safe, flexible, and stable financial system in the United States.

“One of the most important things to understand about the Fed is that it has a dual mandate from Congress,” explained Tendayi Kapfidze, chief economist for LendingTree. In other words, that means the Fed has two jobs: “It needs to keep inflation in check, and promote full employment.”

Congress sets the Fed’s objectives, but the Fed has a lot of latitude to achieve its objectives. Members of the Federal Open Market Committee (FOMC) set the Fed’s national policy.

The FOMC considers thousands of pieces of data when it sets policy. For starters, it considers analyses and reports from over 300 economists. It also pays particular attention to inflation and employment statistics, as well as different economic sectors and regional reports. Its goal is to set policy based on a complete understanding of the economy.

After analyzing mountains of data, the FOMC sets a target Federal funds rate. The Federal funds rate is the interest rate that banks charge when they lend money to each other overnight. It also decides which assets to buy or sell that will influence it’ long-term balance sheet.

What role does the Fed play in mortgage refinancing rates?

Once the FOMC sets national monetary policy, the Fed uses monetary policy tools to implement the policy. Most of the Fed’s actions influence short-term interest rates like the Federal funds rate. The Federal funds rate is the rate that banks charge one another for overnight loans. The rate influences short-term borrowing and lending behavior. It actually doesn’t have much effect on long-term rates like mortgage refinance interest rates.

A common misconception about the Fed is it actually sets rates on mortgages and mortgage refinances. It doesn’t. What really drives mortgage rates higher is when market forces influence on mortgage refinance rates and all other mortgage rates. According to Kapfidze, mortgage lenders set rates based on the current yield on long-term U.S. Treasuries plus a targeted spread. Lenders then sell bundles of mortgages in the bond market as mortgage-backed securities.

The Fed cannot influence how lenders set their rates on mortgages. Instead, the Fed can influence rates by buying and selling U.S. Treasuries and mortgage-backed securities in the bond market.

“The Fed really influences mortgage rates by what it keeps on its balance sheet,” Kapfidze said.

Does the Fed funds rate influence mortgage refinance rates?

Despite popular belief, the Fed funds rate has almost no bearing on mortgage refinance rates.

“The Fed funds rate is an overnight rate, but Treasury securities and mortgages have much longer maturities,” Kapfidze explained. “The activities that influence the Fed funds rate aren’t the same activities that influence mortgages.” In fact, it’s possible for the Fed funds rate and mortgage interest rates to move in opposite directions (as they did from 2001 to 2006).

It’s almost impossible to predict how changes to the target federal funds rate will affect the mortgage interest rates. If you’re considering when to refinance your mortgage, it’s much more important to pay attention to current mortgage rates than to changes in the target federal funds rate.

Understanding open market operations

Prior to 2008, the Fed primarily bought and sold short-term securities that influenced short-term interest rates. However, the financial crisis of prompted the Fed to take a longer-term approach to monetary policy. In particular, it targeted lower mortgage interest rates by buying long-term assets. Buying these long-term securities coincided with lower mortgage interest rates. Over the past decade, the Fed continued to grow and then stabilize a larger balance sheet.

Suddenly selling off all of the Fed’s assets could put the mortgage market back in turmoil (with mortgage rates quickly rising). Because of that, the Fed is pursuing a policy of slowly letting a limited amount of assets “roll off” its balance sheet.

It’s important to note that the Fed needs to buy or sell billions of dollars worth of assets to move interest rates by even a tenth of a point.

Between 2008 to 2014, the Federal Reserve added trillions of dollars of long-term assets to its balance sheet. It added these assets in an effort to reduce long-term interest rates (especially mortgage interest rates). By buying long-term securities, the Federal Reserve’s reduced the spread between mortgage-backed securities and U.S. Treasuries. It also drove down yields on U.S. Treasuries. Together, these actions led to lower mortgage interest rates.

In particular, the Federal Reserve is often credited with reducing mortgage rates by reducing an excessive risk premium in the market for mortgage-backed securities. Despite all the Fed’s purchases between 2008 and 2014, it never actually set rates on mortgages. Its indirect actions influenced rates downward.

More recently, the Fed has started to normalize its operations. Its balance sheet is slowly shrinking as it stops reinvesting in Treasuries and mortgage-backed securities. With the Fed buying fewer assets, borrowers can expect to see rates on mortgage refinances becoming more influenced by forces outside of the Fed’s open market operations.

The Fed’s open market operations and the bond market

To implement its long-term fiscal policy, the Fed must buy or sell assets at competitive rates with private investors. That means the Fed’s intended policy objectives (such as lowering mortgage interest rates) have to flow through the bond market first.

For example, in 2008, the Fed started to buy U.S. Treasuries and mortgage-backed securities. The Fed wanted to reduce the spread between long-term Treasuries and mortgage-backed securities, which were excessively high by historical standards. However, the effect of the Fed’s policy wasn’t felt right away. In fact, it took several months before the spread between U.S. Treasury yields and mortgage-backed securities fell to historically normal levels.

Now that the Fed is pursuing “normalization” policies it’s no longer investing as aggressively in Treasuries and mortgage-backed securities. However, the effect of this policy has been slow to flow through to mortgage interest rates. In fact, the Fed introduced normalization policies in late 2014, but mortgage interest rates continued to fall until late 2016. The Fed is intentionally taking a slow approach to reducing its balance sheet. In fact, the approach is so gradual that the Fed’s actions may have very little bearing on changes to mortgage interest rates.

How the Fed’s decisions impact you

Now that the Fed has adopted a normalization policy, mortgage refinance rates are starting to rise. With higher interest rates, fewer people can save money by refinancing. In 2012, the $1.51 trillion in mortgage refinances accounted for over 70% of all mortgage originations. Projections from government securitizing enterprise Freddie Mac show that mortgage originations will be down to $460 billion in 2018, accounting for just 29% of all originations.

As interest rates rise, refinancing becomes less and less appealing on average. However, this rule may have one important exception. Borrowers who currently have adjustable-rate mortgages may become more eager to lock in a fixed rate while mortgage interest rates are still near historic lows.

Should you pay attention to the Fed to decide when to refinance?

Knowing the best time to refinance your mortgage is an impossible task. Changes to the Federal funds rate have little bearing on current mortgage rates. Plus, the Fed’s slow approach to long-term normalization means that mortgage interest rates aren’t going to drastically change based on the Fed’s actions.

As the economy and the financial system change, the Fed’s policies will change, too. It may be prudent to refinance your mortgage while rates are still near historic lows, but that isn’t always the case. Before rushing out to refinance, look at mortgage refinance rates, consider how long you plan to stay in your current home and decide whether refinancing makes sense right now.